Harvest time at Australian Vintage

I’ve bought some AVG shares over the past few days. What I find attractive about this business is that it looks like a successful turn-around story, where an underlying trend of structural margin improvement combined with financial de-leveraging has led to strong earnings growth and to an eventual re-rating of the stock. If Management continue to execute as they currently are, and given the Company’s present valuation multiples, I can still see ample room for further re-rating, as well as the potential for long-term revenue and earnings growth.

Revenue and Gross Margin

Looking at the top line, one can see that Total Revenue has been rather flat over the past five years, with a CAGR of merely +3.0% pa between FY2015 and FY2020. On the other hand, revenue from branded wines has been growing a lot more strongly (+8.6% CAGR between FY2015 and FY2020, and with an acceleration to +20% in 1H2021 vs 1H2020); this change in the sales mix has also been the main driver of an uptrend in Gross Margin, which has steadily improved from less than 26% in FY2015 to over 31% in 1H2021.

Conversely, revenue from the lower-margin operations of the Company (bulk wine sales, contract processing and packaging, etc.) is becoming a smaller and smaller percentage of Total Revenue (~27% in 1H2021). Incidentally, this is also where problems have arisen during the Company’s history, for instance in the form of onerous grape supply contracts.

In addition to the growth in Brands revenue, new verticals are also being been successfully explored, most notably non-alcoholic wines under the McGuigan Zero brand; with Brands representing an increasingly large portion of total sales, this bodes well for sustainable future revenue growth.

So, while Covid-19 has been a net positive for the overall business, the Total Revenue growth observed in 1H2021 (+7.8% vs 1H2020) is more likely to be the starting point of a new uptrend, rather than just an outlier in an otherwise flattish multi-year revenue environment. In particular, if one focusses on Gross Profit alone, the observed CAGR between December 2015 and December 2020 has ben a non-insignificant +7.0% pa, thanks to the change in sales mix and consequent margin improvement.

Interestingly, as was pointed out during the last earnings call, the spirits derived as a by-product from the alcohol removal process used to produce McGuigan Zero can be sold in the market at a virtually 100% gross margin; this “side business” is currently generating only ~0.6m$ pa in EBIT, but it could become a significant boost to future earnings, if non-alcoholic wine sales grow into a meaningful portion of total Brands revenue.

It also needs to be noted that China at the moment represents less than 2% of total sales, so the direct impact from the MOFCOM anti-dumping investigation is negligible; also, the risk of oversupply deriving from other Australian producers re-directing their sales away from China is unlikely to materially affect AVG, as the Chinese consumer is mostly focussed on premium red wines, which only represent a very small percentage (~1%) of AVG’s brand portfolio. Unlike its bigger brethren TWE, AVG is more akin to a FMCG company than to a premium wine producer.

Speaking of FMCG, it is important to point out that, unlike many other businesses in that sector (or in the broader Australian retail sector), AVG has a) most of its costs denominated in Australian dollars, and b) a significant portion (>50%) of revenue denominated in foreign currency (mostly GBP). Therefore, none of the most recent improvement in GM is due to appreciation of the AUD; if anything, that has acted as a headwind.

In terms of geographic expansion, the UK and Ireland appear to be the markets with the strongest growth momentum at present, representing already ~50% of total revenue and growing at ~14% YoY; this trend is expected to continue as a result of i) the reopening of the UK economy, and ii) better penetration of the local distribution channels (Sainsbury’s, Tesco, etc.). North-American and continental European sales are still marginal, although progress has been made in those regions at the EBIT level by shutting down some loss-making operations (e.g. bulk wine sales).

Operating efficiencies, financial de-leveraging and accelerating FCF generation

While, as seen above, AVG’s Gross Profit increased at a +7.0% pa CAGR between December 2015 and December 2020, their Cost of Doing Business merely grew at a +1.1% pa CAGR over the same period; as a result, Underlying EBIT growth has been very strong, with a +20.4% pa CAGR.

As the Company have not been paying Income Tax in cash over this period of time, but have simply been running down their Deferred Tax Assets accumulated over previous years (down to a non-insignificant residual level of 19.3m$), Free Cash Flow generation has been accelerating at an even faster pace, allowing AVG to reduce their [Net Debt]/EBITDA ratio from as high as 4.5x in FY2017 to less than 1.5x as of today.

The two charts below show the sharp acceleration in Free Cash Flow over recent years and the corresponding downward trajectory in [Net Debt]/EBITDA. In the Free Cash Flow chart, “Adjusted FCF” represents Free Cash Flow adjusted by changes in Working Capital, which shows that cash generation has largely been achieved without running down Inventory and Net Receivables.

Admittedly, the Company did raise 16.5m$ in fresh capital in May 2017 (although they managed to do so at a premium to market, and securing a new strategic investor in China), but the vast majority of those funds was directed towards capital projects such as the Buronga Hill Winery and the Merbein packaging facility. The benefits from this round of capital expenditure are being felt today in the form of enhanced production efficiency; also, ongoing “sustaining” Capex needs have been scaled down to just in line with the annual depreciation rate.

So, at its current level of financial gearing, operating leverage and Gross Profit growth prospects, I see it fair to say that AVG is essentially in the best shape it has ever been throughout its 13-year-long listed history.

Valuation and investment rationale at current price

At a Price-to-Book ratio of ~0.65x (excluding AASB16-related items), Price-to-NTA of 0.77x, FY2021E PE of ~10.8x (relative to the mid-point guidance of 19m$ NPAT) and FY2021E EV/EBIT of ~8.5x, AVG’s valuation certainly does not look demanding, relative to the current financial/operating health of the business and to the broader market valuations; in particular, relative to the Adjusted FCF (see definition above) generated over the past twelve months, the current Market Cap represents a multiple of merely ~7.4x.

In terms of downside risks, it needs to be remembered that this remains at its core an agricultural business, which means it is relatively capital-intensive, with a relatively low Return on Capital Employed (7%-8% pa at current levels), prone to periods of oversupply and exposed to a whole range of climate- and weather-related issues.

On the other hand, it could also be argued that a significant round of capital investment has only recently been completed, and yet a buyer at today’s price can purchase those assets at two thirds of their book value.

Given the low valuation starting point and the positive underlying momentum of the business, I personally don’t see why the stock shouldn’t continue in its re-rating (as long as Management keep delivering on their execution plan) and converge at least towards its Book Value. For illustration purposes, a 0.90x PB would correspond in earnings terms to a PE of ~14.9x and to an EV/EBIT of 11.1x, which still wouldn’t look demanding; in SP terms, though, that would represent a +40% upside relative to current price; at Book Value (slightly more ambitiously) the upside to the current SP would be around +55%.

Beside the potential for further capital appreciation, AVG looks to me like an interesting proposition even purely from a (risk-adjusted) yield perspective, in light the 70% dividend payout ratio currently being targeted, as well as other capital management initiatives being contemplated by the Company.

To conclude, I have made this a 1%*NAV position, for the time being, and will contemplate adding further to my holding depending on continued successful execution and valuation.

As always DYOR, and all the usual caveats apply.

Cheers